What Next For The Stock Market?

The Daily Capitalist: In a recent post, I presented evidence that there is in many circles a great deal of optimism about the future for the U.S. economy. Evidence for the extent of this optimism continues to accumulate, and not only for the U.S. Bloomberg.com reports

with a headline that is a bit ironic, in that 18 months ago was close to the last intermediate stock market peak (LINK):

World Economy in Best Shape for 18 Months, Poll Shows

The world economy is in its best shape in 18 months as China’s prospects improve and the U.S. looks likely to avoid the so-called fiscal cliff, according to the latest Bloomberg Global Poll of investors.

Two-thirds of the 862 surveyed described the global economy as either stable or improving. That’s up from just over half who said that in September and is the most since May 2011.

The U.S. came out on top for the eighth straight quarter when investors were asked which markets will offer the best opportunities over the next year. China ranked second, reversing a decline to fourth in the September poll of investors, analysts and traders who are Bloomberg subscribers. The European Union, beset by a debt crisis, was seen offering the worst returns.

“The global economy is improving, recovering and healing, thanks to the U.S. and the emerging markets,” said Andrea Guzzi, a poll respondent and vice president of IST Investmentstiftung fuer Personalvorsorge, which manages money for Swiss pension funds. “More people are becoming wealthy, less and less are poor.”

In America, are fewer people really becoming poor? Gallup has just reported on recent trends in consumer spending, comparing 2012 to 2011. Their data is not adjusted for price changes, which except for the usual mild electronic products deflation, have moved up, so the real year-on-year comparisons are worse than they look, and the numbers even in nominal terms are not inspiring (LINK):

This metric, which Gallup takes as a good proxy for self-reported consumer discretionary spending, has been at or below 2011 levels almost continuously since mid-October, and has basically gone nowhere for four years (LINK). Given that the poll does not adjust for inflation, real spending is down on a per capita basis from four years ago.

So, why is it that Ms.Guzzi, quoted above in the lede, thanks the U.S. for making more people rich and fewer poor? A good, and fair, question, one might think.

In any case, trend-f0llowing continues in the above Bloomberg poll that involved Ms. Guzzi:

Stocks were seen as the asset of choice, with more than one in three of those surveyed on Nov. 27 forecasting equities would have the best returns in the coming year. Real estate came in second: Just less than one in five investors singled it out favorably, the best showing since the quarterly poll began in July 2009. Bonds were seen as offering the worst returns.

Bloomberg.com is at the epicenter of data dissemination of the global financial markets. Mayor Bloomberg, whose publication picked unmercifully on Mitt Romney’s wealth during the campaign, is estimated to be approximately 100 times wealthier than Mr. Romney. The financial powers that be make a lot more money from stock trading than from selling bonds, which are often held to maturity. So it is in their plain self-interest to promote stocks. Which they usually do.

However, the big individual money in America, Europe and Japan, belongs to the retired and those nearing retirement: i.e., the elderly and wanna-be elderly. The secular bull market in stocks that began in 1948 occurred when stocks were feared and despised, and when working people saved and invested much more robustly than now. Most people then either feared or even expected another Depression. Now, as I showed a few days ago, a lot of vocal people are confident that it’s 1997 again in America (I ignore that the average stock peaked in 1998, as did corporate profits).

Times now are very, very different from the Clinton years. The idea that consumer spending in America would be down in nominal dollars compared to the prior year would have been considered ludicrous only a few years ago. (The norm was about 7% nominal consumer spending growth in the Clinton era, with peaks higher.)

Did you notice the reference to peak optimism in the above poll, the highest since May 2011? That month marked the peak for several broad measures of U.S. stocks, such as the NYSE Composite Index and the Russell 2000. In contrast, the “generals” have marched higher. This is a similar divergence to that which began to be seen in 1997-8. What else has marched higher since May 2011? Those old standbys, gold and Treasury bond prices. The “total returns” from these have beaten the S&P 500 over multiple time horizons.

Given the subtle underperformance of U.S. stocks since May 2011 versus the boring assets of gold and bonds, and the demographics that inexorably will lead most individual investors to continue to favor the greater predictability of bonds over stocks, it is curious that these big money investors think bonds are the worst investments – even though bonds have beaten stocks in the U.S. at almost every time frame one can imagine for more than thirty years. Why do these investors not think that the Japanese financial scenario is not likely to continue to appear in the U.S.?

We are beginning to see catalysts for a bear market. An important criterion for the possibility of a major one is that stocks are rich by long term historical standards. Thus, from record overvaluation in stocks, the mild 2001 recession was associated with a vicious bear market. Andrew Smithers, a British economist, quantifies this graphically (LINK, and see text explaining and quantifying his estimate of stock overvaluation):

Second, unfortunately some significant new financial strains are appearing, as started becoming apparent in 2007. In addition to increasingly acute problems with the U.S. Postal Service, sadly there is this recent headline regarding the Federal agency that issues Ginnie Mae bonds, and which expanded its lending drastically after Fannie Mae and Freddie Mac collapsed in late summer 2008 (LINK to blog post):

Last but decidedly not least, there may be a student loan bubble that is now bursting, as the New York Fed reported this week (LINK):

Outstanding student loan balances increased to $956 billion as of September 30, 2012, an increase of $42 billion from

the previous quarter. However, of the $42 billion, $23 billion is new debt while the remaining $19 billion is attributed to

previously defaulted student loans that have been newly updated on credit reports this quarter2

• This increase has boosted the delinquency rate for student loans balances. The percent of student loan balances 90 or

more days delinquent stands at 11.0%

With footnote of importance (emphasis added):

As explained in a recent blog post, these delinquency rates for student loans are likely to understate actual delinquency rates because almost half of these

loans are currently in deferment or in grace periods and therefore temporarily not in the repayment cycle. This implies that among loans in the repayment cycle delinquency rates are roughly twice as high.

Bloomberg provides a chart today that depicts this as well as other default rates graphically (LINK). All default rates measured remain above levels that prevailed when the “Great Recession” began.

In addition to the above, today there was a contentious interview on Bloomberg News recorded today between the public face of ECRI, Lakshman Achuthan, and a team of questioners (link at businesscycle.com, also LINK to associated ECRI document released today). There was a high degree of aggressive skepticism to his recession call; the host, Tom Keene, said the call was “wrong”. ECRI now dates the recession as having begun in July. From a market standpoint, a recession that occurs in fearful times, such as the 1948 recession, has in the past been almost a non-event for stocks. When one occurs at a time when informed interviewers on Bloomberg TV just can’t accept that a top-tier analyst might be correct, then that if real evidence of a recession appears, there might suddenly be a lot of eager sellers trying to unload stocks exactly at the time that eager buyers suddenly become scarce.

The combination of bullish, trend-following sentiment on U.S. stocks; the unsolved European economic-financial problems; joyous sentiment that the Keynesian solution to the financial crisis is about to work; weakening corporate profit trends; high and rising dividend cuts by public companies; disbelief that the U.S. might just be in its 48th recession (or, depression); new crises at the FHA and in student loans; and rich stock market valuations by many criteria combine to suggest that U.S. stocks are riskier than usual now. Might CNBC be dusting off its Dow 10K hats next year? (Of course, the proper answer is on the lines of “Who knows?”. Perhaps fairly soon they will instead be ordering Dow 20K hats. Stranger things have happened.)

It is important to be clear on what is not being said here. Nothing here is “doom and gloom”. The world will not end if the U.S. is in another recession, or enters one soon; or if stock prices decline more than a bit. Long term stock market investors are often wisest just ignoring the year-to-year ups and downs of the averages. This is especially true for people for whom putting new money into stocks when the news flow is terrible and stocks are “acting poorly” is not easy. But active portfolio managers, as well as people making business or personal financial decisions, may want to seriously consider the short-term and intermediate-term downside risks both to the performance of the United States economy and its stock markets.

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